Warner Bros. Discovery (WBD -0.71%), a leading media and entertainment company created from the merger of WarnerMedia and Discovery, is having a tough time in the market as evidenced by its 50% decline post-merger.
That may tempt investors looking for high-quality bargains in this bear market, but before rushing into the stock, it's crucial to learn more about the core risks and opportunities that lie ahead for the company.
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Warner Bros. Discovery's cash-generation machine
The media industry is more competitive than ever thanks to the rise of players like Netflix and Amazon, among others. In that light, the merger between WarnerMedia and Discovery makes a lot of sense since it creates a behemoth with the necessary scale to compete in this evolving industry. It also creates a highly-diversified media company with revenue derived from multiple segments, locally and abroad.
The biggest income generator comes from the network businesses, accounting for 57% of the conglomerate's second-quarter revenue. Warner Bros. Discovery owns some of the most popular networks, including CNN, Discovery, HGTV, and Eurosport, to name a few. Within this business, the company generates revenue mainly from advertising income and content distribution.
The studio segment is the next biggest revenue source. It includes popular franchises like Friends, The Big Bang Theory, Batman, Superman, and Harry Porter. Here, the company generates revenue from licensing fees customers pay to air its content in cinemas, on television, on streaming platforms, and elsewhere. This segment accounts for 31% of the company's revenue.
The last segment is the direct-to-consumer (DTC) business operating under HBO, HBO Max, and Discovery+. Streaming subscribers get access to premium on-demand content by paying a monthly fee. In general, the DTC business bundles the content from Warner Bros. Discovery's networks and studios and then redistributes the content to consumers.
Together, these segments generated $10.8 billion of revenue in the second quarter, $1.8 billion in adjusted EBITDA, and $789 million of free cash flow. However, the network and studio segments continue to fund losses in the DTC business.
There are massive opportunities ahead
When the management teams of Discovery and AT&T decided to combine their media businesses, they saw major synergies the combined company could exploit, both in terms of revenue and cost structure.
For the former, the new company can start offering a compelling subscription service by combining the content library from WarnerMedia and Discovery. For example, the company recently announced its plan to combine Discovery+ and HBO Max into a single direct-to-consumer service. Because Discovery already has a global distribution channel, it's in a favorable position to offer WarnerMedia content (such as HBO) globally at a low marginal cost.
In terms of cost savings, the combined company can remove duplicated costs -- marketing, administration, operation -- from its cost structure. Moreover, the new company has greater scale, giving it more bargaining power across its procurement activities.
Overall, Warner Bros. Discovery expects annual synergies of $2 to $3 billion in 2023 and more than $3 billion in 2024.
But investors need to consider the risks
Still, there are risks involved in a massive transaction like this. One thing is the enormous integration and execution risk. The difference in culture, necessary planning, and other factors can result in struggles for the new entity. Besides, it doesn't help that Warner Bros. Discovery has a massive debt balance of $49.1 billion (net of cash), adding another layer of uncertainty for investors to consider.
On a slightly positive note, this is not the first time David Zaslav (the CEO of legacy Discovery and the newly formed company) and his team have entered into such a huge transaction. A few years ago (in 2018), Discovery acquired Scripps Networks for $14.6 billion. The same group is in action again, albeit on a larger scale.
Besides, Warner Bros. Discovery is in an excellent position to pay down the debt over time thanks to its profitable business. For perspective, the company expects to generate $9.0 to $9.5 billion in pro-forma EBITDA this year. To this end, management is targeting a long-term gross leverage ratio of 2.5x to 3.0x (gross debt divided by trailing-12-month EBITDA) by 2024. It also helps to know that 87% of the debt has a fixed interest rate -- thus, a higher interest rate environment will have minimal impact on interest expenses.
While the elevated risks that come with investing in Warner Bros. Discovery will likely mean greater volatility in the near term, management has a clear vision for the new company. That said, investors should closely track whether the leadership team can deliver on its ambitious targets for the business, profitability, and balance sheet.
